Expert Zone

Straight from the Specialists

Should public debt be subject to a ceiling?

March 9, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Finally debt is receiving serious attention. The finance minister reminded the states about the road map laid out by the 13th Finance Commission which requires that they eliminate the revenue deficit and restrict the fiscal deficit to 3% of their respective Gross State Domestic Product so that the combined state debt will not exceed 24.3% of GDP by 2014-15.

The Centre has its own debt to manage which will now be entrusted to a separate debt management office. But the larger question is whether public debt should be subject to a ceiling. There are no accepted norms to go by though the fiscal responsibility and Budget Management Act, which was observed more in breach than in substance and will now be made more flexible, indicated limiting fiscal deficit to 3% of GDP.

Every government borrows, some more than others. There are occasions when governments borrow for emergencies. In 2008-09, for instance, almost every government borrowed far too much to counter the crisis that had spread worldwide. That was not without problems either. Some of the European countries could not service sovereign debt and had to be bailed out by the IMF and ECB.

External debt can be a greater danger. No wonder Indian government has been giving close attention to external debt though there is some indifference towards rupee debt possibly in the belief that it can always be repaid from tax revenues or additional borrowing.

Of the total public debt of Rs.39.3 trillion, only 4% is external debt. That would be less than 2% of the GDP well within safe limits.

The government has however recklessly indulged in rupee debt largely to fund the revenue deficits. This had adverse consequences. First, more than a third of the tax revenues of the centre are now eaten up by interest on public debt.

Second, excessive borrowing by government led to overcrowding of the market, reduced the amount of funds available for private investment and increased interest rates. Since productivity is lower in public sector, excessive borrowing by government lowered the rate of growth of the economy.

Private sector also borrows but it uses the loans to buy capital assets which earn more than the interest rate. That is not so with government and that is what makes public debt a burden.

Loans have been used more to fund current expenditure with no corresponding asset cover or income. For instance, at the end of March 2011, against 54% of the loans there were no assets and therefore no income.

The financial crisis of 2008 underlined the necessity of room for counter cyclical initiatives by government to prevent the economy from running into recession. That room can be created if the ratio of public debt to GDP is less than 60-65%, according to an IMF study. That means the centre will have to bring down its debt to about 40% of GDP from the current 50% in three years. That is not an easy target.

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  • Editors & Key Contributors